Current issues in economics

Tag Archives: Depression

In 2007 the world economy was thrown into turmoil as the subprime housing crisis in the USA started a chain reaction around the world. Although developments dating back to the 1970s led to increased risk-taking as markets became less regulated. In total it is estimated that the loss to the global economy was US$15 trillion. But it could have been worse if it wasn’t for the lessons learned from the Great Depression of the 1930’s.

What did policymakers do better in 2008 compared to 1929?

Government’s in 2008 were a lot more active in pumping money into the circular flow and their budgets became a much bigger share of the economy, thanks partly to the rise of the modern social safety net. As a result government borrowing and spending on benefits did far more to stabilize the economy than they did during the Depression. Also policymakers stepped in to prevent the extraordinary collapse in prices and incomes experienced in the 1930’s. Although unpopular government’s bailed out banks and prevented panic like that in the Depression were there was a ‘run on the banks’ – about half the banks in the USA closed after 1929. This prevented an implosion of the global economy. But after the Depression government’s were forced into radical reforms to correct the economy which ultimately led to 50 years of economic stability. This wasn’t the case with the GFC in that the success of government policies meant that they avoided the radical reforms of the 1930’s – the disposing of the gold standard. So does this mean that the global economy is still vulnerable to the same variables that caused the problem in the first place?

Financial Reforms
To explain the root cause of the 2008 financial crisis George Soros uses an oil tanker as a metaphor. In the movie documentary “Inside Job” he basically said that markets are inherently unstable and there needs to be some sort of regulation along the way. The oil tanker has quite an vast frame and, in order to stop the movement of oil from making the tanker unstable, shipping manufacturers have designed them with approximately 8-12 compartments, depending on the size. This maintains the tanker’s stability in the water.

After the Depression the Glass Stegal Act was passed in 1933. This act separated investment and commercial banking activities. At the time, “improper banking activity”, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors’ money. Therefore to use Soros’ metaphor, a compartment was put into the tanker to make it more stable.

However, in 1999 Gramm–Leach–Bliley Act effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which accepted deposits. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. Therefore, the tanker had a compartment/s removed which made it very unstable and it eventually capsized. Consequently the deregulation of financial markets has led to the end of compartmentalisation.

Post Depression Roosevelt restored growth and made up for what was lost during the depression years but post GFC there have been no major reforms of capital flows and the concentration of the financial sector’s weight in the global economy hasn’t changed. Also central banks have not tried to make-up the lost output and as a result the recovery has been weak. Monetary policy has had to remain very much expansionary and will take time before it returns to a neutral rate. This means when the next recession comes around monetary policy will become ineffective with little ammunition left as rates are so low. However, the main issue is that the fundamental problems that caused the GFC are still there.